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03/31/2013

Business Ethics—Posner

There has been an unprecedented drumbeat of accusations of unethical behavior by American (and foreign) business firms. The accusations that have gotten the most publicity concern, naturally enough in light of the financial collapse of 2008 and the worldwide economic depression that ensued and is still with us, banks (both commercial banks, like Citigroup and JP Morgan Chase, and “nonbank banks” such as Goldman Sachs and Lehman Brothers), related entities, such as mortgage brokers, hedge funds (accused of widespread insider trading), Ponzi schemes (such as Madoff’s); ratings firms such as Standard & Poor’s; pharmaceutical companies; other for-profit medical providers; law firms (accused of padding bills); manufacturers and retailers of foods (accused of engaging in misleading marketing practices that contribute to the nation’s obesity and diabetes epidemics); Internet search firms (such as Google) and social media (such as Facebrook) (accused of invasions of privacy); for-profit colleges and vocational schools (accused of misleading applicants). Although I am calling these accusations ones of unethical behavior, most of them violate either criminal or civil law. Business behavior that is unethical but probably not also illegal would include such things as packing a corporate board of directors with patsies who do not act as representatives of the shareholders (as they are supposed to) but are in the pocket of the CEO, the confusing disclosure of credit terms, exploitation of consumers’ difficulty in understanding interest rates, and hiring pretty girls to hawk new drugs to physicians.

There is nothing new about unethical business behavior. Nor is it confined to “business” in the sense of for-profit private enterprise. Most colleges and universities are nonprofit, but they have come under searing criticism of late for exorbitant administrative salaries, excessive tuition, and misrepresentations of the job opportunities of their graduates (law schools have become particular offenders in this regard). Regulators are accused of going easy on the regulated because they hope to be hired by a firm they are regulating after their stint of government service. State legislatures are accused of vote suppression, and donations to political campaigns are criticized as quasi-bribery.

Nor is it possible to say that there is more unethical behavior in business (broadly defined to include any provision of goods or services—the “market” in the broadest sense) today than there was ten or twenty or a hundred years ago. My guess is that, given the growth of regulation and expansion in legal remedies, there is less today than there was fifty or a hundred years ago. It is mainly anger at the banks, widely blamed for our economic troubles since 2008, and the increased scope and penetration of the electronic media, that are responsible for the fact that unethical business behavior is receiving much more publicity than in times past.

Yet the publicity on how widespread unethical behavior is should invite a critical look at the free-market ideology that is both a cornerstone of conservative ideology and politics and a highly influential current of economic thinking generally. It is the current typified by the popular economic writings of Milton Friedman and by Alan Greenspan’s contention (before the 2008 crash) that financial markets, and by extension markets generally, are “self-regulating”: they operate efficiently with little or no regulatory supervision by the government. Which we now know to be false, at least in the case of finance.

Competition is doubtless essential to the efficient production and distribution of goods and services. But it is not an antidote to unethical practices by producers and distributors. There are three problems. One is the limitations of negative advertising. Suppose a cigarette manufacturer discovers a way of reducing the incidence of lung cancer among heavy smokers by 50 percent. Can one imagine an ad that said: “if you’re a heavy smoker, switch to our cigarettes—it will reduce the likelihood of your getting lung cancer (as a result of smoking heavily) by 50 percent”? The advertiser would be poisoning his own well. Problems are often common to an entire market, and advertising that touches on a common problem tends to be self-defeating (“our airplanes crash only half as often as our competitor’ planes”; “airbags are more likely than our competitors’ to prevent your chest from being crushed by the steering wheel in a head-on collision”).

A second and related problem is created by cognitive and informational deficiencies that weaken theeffectiveness of consumers as enforcers of competition that enhances consumer welfare. For example, quoting prices that are not rounded to a dollar is a wasteful practice; it slows down transactions, increases record-keeping expenses, and is a drain on the U.S. Mint, because a penny costs more than a penny to produce. But sellers understand that a price of $7.00 strikes many consumers as substantially greater than a price of $6.99, and knowing this sellers are extremely reluctant to round.

Third, most competition is between organizations, and organizations are composed of people whose utility functions are not identical to that of the organization. Organizations are often nests of intrigue, where striving for personal advance can disserve organizational goals. This is true at the highest level; a CEO may be far more concerned with his salary than with the value of the corporation, and may (within limits of course) be able to promote the former at the expense of the latter. CEOs often as I said earlier try to pack the board of directors with friends and patsies, generously compensated for doing very little, so that the CEO’s salary will not be questioned and his tenure will be secure.

The legislative process is frequently and justly criticized on the ground that legislators’ horizon (oftenjust the next election) tends to be truncated, causing them to ignore long-term costs and benefits. But the same often is true in business, especially finance, where short-term profits may be enormous, as they were in the housing and credit bubbles of the early 2000s. It will often make sense from an individual trader’s perspective to take very great risks, if from a statistical standpoint the risks are unlikely to materialize until after substantial profits have been earned.

All the tendencies to inefficiency that are inherent in a market economy are actually magnified in the United States by the intensity of competition, as well as by inequality of incomes and the weakness of the social safety net, a prevalent free-market ideology that has given rise to strong political opposition to regulation, the enormous publicity that is given to wealthy people and the widespread public dissemination of affluent people’s incomes and wealth, the limited prestige of most careers that are not lucrative, the absence of aristocracy, which would provide an alternative ladder of success to money, and the American tendency to attribute financial success to skill and hard work even when it is largely attributable (as often it is, especially though not only in financial markets) to luck.

Extremely lax regulation, especially by the Securities and Exchange Commission, which regulated "nonbank banks” like the ill-fated Lehman Brothers) but also by the Federal Reserve, other federal banking regulators, and state insurance regulators, and spotty regulation of foods, drugs, and medical devices would not be problems if markets were really self-regulating, as Greenspan thought. They are not. We probably need stronger regulation. The danger is excessive regulation, which gave rise to the deregulation movement that began in the late 1970s, and had on the whole beneficial effects (though not in finance—the deregulators did not appreciate the potential macroeconomic consequences of a financial crisis). A balance is difficult to achieve. But the pendulum may have swung too far in the direction of deregulation.

Comments

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I have no idea whether the total quantity of unethical behavior in government and industry is now greater than it has been in the past. I do not even know how I would go about trying to assess such a claim. But I do find Judge Posner's examples of greed-plus-organizational imperfection both plausible and scary. They remind me of nothing so much as the Hellfire-and-damnation sermons I encountered as a young man, which also assembled a convincing list of failings that were certain to lead to damnation unless reformed as soon as possible.

Judge Posner's form of reformation would involve more governmental regulation, a solution I would find more appealing if it could be shown that such regulation as we have had has been more inspiring than I suspect. In the absence of such a showing, I shall rely, as best I can, upon the true but uninstructive advice of Proverbs 17.12: "Let a bear robbed of her whelps meet a man, rather than a fool in his folly."

I'm not sure additional regulation is the answer; more likely, it's verification. We have plenty of rules of things not to do, in the financial sector for example, but we did not discover that those things were in fact being done, until it was too late. Secondly, we need consequences for violation. Bank of America's stockholders are taking a hit, but the actual actors have skated, with their ill-gotten wealth and freedom intact. The 2008 crisis was not a failure of markets, or finance, or capitalism. It was a failure of law.

Friedman was wrong in his conception of market mechanisms, not because they aren't self-regulating - to a very large extent, they are - but rather because they are not perfectly elastic, even when perfect information is available. The reason is, per Judge Posner's point, that the self-interest of the individuals actually doing the work is not perfectly aligned with the interest of the organizations they serve. In the years leading up to 2008, somebody somewhere on Wall Street must have realized that credit default swaps were riskier than the conventional wisdom was allowing. (This fact was obvious to me at the time, and I'm an outsider.) I am thus confident that some of these guys did know they were trading dookie. One of them might have said to himself, I should get my bank out of these grossly underappreciated risks, and 5 years from now I'll be a hero when we are solvent and everybody else is in the tank. In an elastic (and ethical) market, this would have happened, but the peculiar phenotypical quirks of the Wall Street man overrode any such tendencies, and the self-regulation didn't occur.

Inherent in the concept of fiduciary responsibility is the premise that, after all, this is the money we're talking about, and there are people in the world willing to go to extreme lengths and even break the law to acquire it. Banks are supposed to be careful. There is something structurally wrong with the financial sector, but I personally think a few public hangings would go a very long way toward correcting the problem.

Judge Posner's comments, in this blog and in his most recent books, have been quite helpful (at least to me) in understanding the causes that have fed into the financial crisis. His latest argument--that capitalism is not, in fact, self-correcting, and that without effective regulation we are doomed--seems less persuasive to me. Surely one of the great lessons of the financial crisis is that central bankers are no more likely to anticipate threats to the finacial system than command economies are likely to match up supply and demand. The economy is just too damned complicated.

I am not sure how we allow failures to occur without touching off massive ruin, but it seems to me that economists like Roubini who are moving in this direction are on a better track. We need somehow to allow the losses to take place and to focus the pain of
them primarily upon those who made them possible.

Business Ethics? Is there a special class or category of Ethics that applies only to "Business" men and the "Business" world? I always thought that Ethics were a Universal that apply to any environment or situation and much like Aristotle, a science of most practical value. Such that, it is the study and analysis of the issues and relationships of Good and Evil, Right and Wrong, Virtue and Vice and their practical applications in regards to human action in any situation. Whether it is "Business" or anything else.

But since we're all backsliders in one way or another, such is the need for Law and Regulations - hopefully with teeth...

I agree with Judge Posner on the social as well as economic benefits of an aristocracy to offset the callous and often anti-social tendencies of business. Aristocrats have a vested interest in maintaining the social mores of a civilization as well as its folkways that provide and sustain their own influence. Businessmen have a much less obvious and direct connection to the cultural foundations of a society. Of course, they too are dependent on these structures, but it might not be as obvious to businessmen in the moment.

When aristocracies wielded more power and influence, many successful businessmen desired to join their class as best they could, so they followed the lead of the aristocrats in taste, morals, and a sense of noblesse oblige to gain entry into the upper class. This made for a more civilized version of free markets such as we saw in England and the American South.